Alberta v ENMAX Energy Corporation, 2018 ABCA 147

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interest on a loan from a tax-exempt parent should be at an arm’s length rate reflecting implicit parental credit support

A corporation (“ENMAX”) that was wholly-owned by the City of Calgary and thus, exempt from income tax, made a subordinated loan of $497M with a term of 10 years and bearing interest at 11.5% per annum to an electricity-distributing wholly-owned subsidiary of ENMAX (“Energy”), and made two similar loans for $309M and $59M bearing interest at 10.3% and 9.9%, respectively, to a subsidiary of Energy (“PSA”) to fund its acquisition of rights to power. Energy and PSA were required by s. 147(3) of the Utilities Act (Alberta) to make “Balancing Pool Payments” (for the ultimate benefit of Alberta energy consumers) equal to the federal and Alberta income tax for which they would have been liable had they not been exempt from income tax. The Alberta Minister of Finance reassessed Energy’s and PSA”s calculation of their Balancing Pool Payments on the basis that the reasonable rate of interest required by s. 20(1)(c)(i)) on the above loans was 5.42%, 5.26%, and 5.24%, respectively.

After indicating (at para. 74) that the Legislature had incorporated the ITA regime “in pursuit of a specific goal: competitive equivalency between municipally-owned and non-municipally-owned companies,” and noting (at para. 77) that “in marked contrast to the ordinary situation under the ITA where a parent has loaned money to a subsidiary” under which “the interest deductible by the subsidiary is brought into income by the parent,” the Court stated (at para. 79) that:

What is reasonable for purposes of calculating taxable income is not necessarily reasonable for purposes of calculating a required Balancing Pool Payment.

Then turning to the reasonableness test under s. 20(1)(c)(i), the Court stated (at paras. 99, 103):

An arm’s length assessment constitutes a necessary proxy for the reasonableness of the interest deduction. …

A parent of a municipal entity is not entitled to gain an advantage over its private competitors by arranging its subsidiaries’ affairs in a way that causes a hypothetical arm’s length loan to appear riskier than it would have been had any reasonable municipal entity actually gone into the market to borrow the funds. Hence the need under the Balancing Pool Payments regime to ensure that the structure of the loan transaction is also objectively reasonable to the extent it would affect a market interest rate.

In accepting the view of the Minister’s experts that the interest rate on a hypothetical arm’s length loan to Energy or PSA would reflect implicit credit support from ENMAX, the Court noted (at para. 113) that “ENMAX would hardly stand idly by while subsidiaries that represented at least half of its net income were forced into insolvency or into the sale of key assets,” and (at para. 116):

[A]ny third party lender would look at the entire corporate structure and see that ENMAX’s viability could not be separated from that of its subsidiaries. An external lender would therefore assume implicit parental support.

arm’s length interest rate to sub could not be manipulated by structuring the loan as a junk bond without implicit parental credit support

A wholly-owned subsidiary (ENMAX) of the City of Calgary made 10-year subordinated term loans to ENMAX power-distribution subsidiaries at interest rates mostly of 11.5% and 10.3%. Although ENMAX itself was tax exempt, the borrowing subs were required to make “Balancing Pool Payments” equivalent to the income tax that would be payable had they not been tax exempt.

The Court confirmed the Alberta Minister of Finance’s reassessments, made on the basis that the that the reasonable rates of interest required by s. 20(1)(c)(i) on the above respective loans was 5.42% and 5.26%, and stated (para. 103):

A parent of a municipal entity is not entitled to gain an advantage over its private competitors by arranging its subsidiaries’ affairs in a way that causes a hypothetical arm’s length loan to appear riskier than it would have been had any reasonable municipal entity actually gone into the market to borrow the funds. Hence the need under the Balancing Pool Payments regime to ensure that the structure of the loan transaction is also objectively reasonable to the extent it would affect a market interest rate.

In also accepting the Minister’s submission that the hypothetical arm’s length loan (in addition to not reflecting the “junk bond” way in which the actual loan had been structured) should reflect implicit credit support by ENMAX (to whom these subs were key assets), the Court stated (para. 116):

[A]ny third party lender would look at the entire corporate structure and see that ENMAX’s viability could not be separated from that of its subsidiaries. An external lender would therefore assume implicit parental support.

A parent of a municipal entity is not entitled to gain an advantage over its private competitors by arranging its subsidiaries’ affairs in a way that causes a hypothetical arm’s length loan to appear riskier than it would have been had any reasonable municipal entity actually gone into the market to borrow the funds. Hence the need under the Balancing Pool Payments regime to ensure that the structure of the loan transaction is also objectively reasonable to the extent it would affect a market interest rate.

In also accepting the Minister’s submission that the hypothetical arm’s length loan (in addition to not reflecting the “junk bond” way in which the actual loan had been structured) should reflect implicit credit support by ENMAX (to whom these subs were key assets), the Court stated (para. 116):

[A]ny third party lender would look at the entire corporate structure and see that ENMAX’s viability could not be separated from that of its subsidiaries. An external lender would therefore assume implicit parental support.

purpose inferred in part from Legislative Assembly statement of Minister

The Court inferred from a response (quoted at para. 21) to an MLA question given by the Minister of Energy in the Alberta legislature - that there was an intention to create “level playing field” between municipally-owned power companies and taxable competitors – that it was contrary to the purpose of a legislative rule requiring such otherwise-exempt companies to make payments in lieu of taxes, to be able to “shelter” their earnings by paying junk-bond interest rates on financing from their exempt parents.

After quoting from Gabco, and in concluding that the reference is s. 20(1)(c)(i), as it applied for the purposes of computing payments to be made by tax-exempt power companies in lieu of income taxes, to a reasonable rate of interest referred to an arm’s length interest rate, the Court stated (at para. 86):

Gabco frames the inquiry in terms of whether no reasonable business person would have contracted to pay the disputed interest. However, the question is not whether there is some imaginable business person who might have agreed to do so even if 99% of reasonable business persons would not have done so. Therefore, we would refine the test this way: would a reasonable business person have contracted to pay the disputed amount of interest taking into account only the business interests of the borrower? This accords with the requirement in Gabco that the test must be objective and with how that test has been applied in later cases: see e.g. Safety Boss Ltd v Canada, 2000 CanLII 216 (TCC), [2000] 3 CTC 2497 at para 27 (FC); TransAlta Corp v Canada, 2012 FCA 20 (CanLII) at paras 74-78, 426 NR 27. In other words, was the interest paid objectively reasonable? Under the Balancing Pool Payments regime, the answer to this question may also require a court to consider whether the terms of the loan were objectively reasonable to the extent those terms affected the interest rate.

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